Popular Stock Market Myths

The stock market is a culture based partly on persistent myths. To a large extent, belief in myths is wishful thinking and, in some cases, magical thinking. This is a belief in something that simply does not make sense. For example, if you believe that watching a baseball game while wearing the team hat or a 'lucky' shirt leads to victory, this is magical thinking.

Key Point

The stock market has many myths, and a large number of investors and traders believe them, even though they are not true.

Magical thinking is quite common.

It is an attempt to find a correlation between acts (wearing a lucky shirt, for example) or rituals (sitting in a lucky chair) and outcomes (a win for your team or profit in your stock). The other side of superstition in magical thinking is the fear that saying a particular thing or doing something causes bad luck or a bad outcome. Actors claim that saying 'good luck' to someone is actually bad luck, preferring 'break a leg' as an opposite form of good wishes. Actors also believe they should never whistle backstage or say 'Macbeth.' These are forms of acts or utterances that are believed to bring about a bad outcome. In the stock market, many investors and traders hold similar beliefs even though they are not always entirely aware of them. Belief in odd timing systems is one example. Some believe that outcomes of the Super Bowl, weather patterns, or even the width of tree rings determine stock market performanceârather than economic trends and the influence of supply and demand.

In the volatile and fast-moving modern stock market, techniques of trading, breadth of markets, costs of trading, and availability of research have all made everything much faster, more efficient, and immediate. However, some popular myths persist. These include:

The entry price of an investment is always the 'zero' point. Many investors and traders operate on the flawed assumption that their entry price is 'zero,' meaning that from that point, prices are going to rise. This might happen, but prices might also fall. It is important to realize that today's price is part of a never-changing struggle between buyers and sellers, and no trend lasts forever.

Buying high-value stocks and then forgetting about them is a wise method. Some value investors advise that conservative investors should not look at the daily stock market news or spend too much time worrying about the price of their stocks. Some have even advised not reviewing the market at all after a good purchase has been made. But there is a balance. The fortunes of today's 'good' companies can change and if and when that happens, even the most conservative buy-and-hold investor will want to get out and replace that company with one that better meets their standards. You might not want to review the market every day, but you do need to monitor what you own periodically to make sure yesterday's positive indicators still hold.

Key Point

Even buy-and-hold strategies require a degree of monitoring to ensure that companies continue to meet the fundamental standards to be kept in the portfolio.

Past mistakes should be studied, analyzed, and revisited in order to improve future performance and avoid the same mistakes. There is a lot to be learned from past mistakes. But many investors and traders find themselves dwelling on their miscues and allowing these errors to affect how they operate today. It is a mistake, for example, to avoid a strategy only because it did not work in the past; it makes more sense to learn from mistakes to help avoid repeating them. Another mistake is to try to earn a larger profit on today's trade to make up for the loss on yesterday's trade. Increasing risks in this manner is not advisable. Always stay with your risk profile. Accept losses. And move forward, not back.

Inside tips give you an edge on everyone else. The persistent belief in the insider tip characterizes a lot of the stock market culture. Two things should be kept in mind, however. First, stock tips are not reliable as a reason to put money in today. Second, a true inside tip from someone with knowledge not available to everyone else is not supposed to be shared. It is illegal to accept and act on insider information. The federal civil and criminal laws governed by the Securities and Exchange Commission (SEC) regulate insider trading. If you get tips from an online chat room, you have no idea who is advising that you buy stocks. Some people buy shares and then promote buying by others to run the price up, so they can sell at a profit. This practice, called pump and dump, is also illegal.

The institutional traders are experts, and individuals cannot compete with them. Big institutional investors (mutual funds, pension plans, insurance companies, for example) may have portfolios in the billions of dollars and hire a team of full-time professional researchers and experts. Ironically, this does not guarantee better-than-average performance, in spite of the myth claiming this. The truth is that most mutual funds perform below market averages:Because of their excessive annual fees and poor execution, approximately 80% of mutual funds underperform the stock market's returns in a typical year. Over the past couple of years, that number has been going up, as mutual funds have been raising their fees to even higher levels. The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general.

Diversification is not a smart way to invest; find a great stock and put all your money into it. A reckless idea is to put all of your money into a single stock, unless you know somehow that the stock's value is going to riseâand of course you cannot know this. Diversifying too broadly does average out your net return, but a moderate level of diversification is just prudent.

Key Point

Diversifi cation is simply smart management. Putting all of your capital at risk on any one company is a high-risk idea.

Successful investors know the secrets to beating the market, but do not always want to share those secrets with others. The fact is, there are no secret formulas to market success. Successful investors or traders earn profits through diligent research, hard work, and learning from their mistakes. There is no 'easy way' to get rich quick.

Day trading and swing trading are the ways to make fast profits. The appeal of a fast turnaround is difficult to resist, but thinking that the day systems are easy and a 'sure thing' is a very risky thing to believe. The science of timing and reading of entry and exit signals is complex and requires experience and practice.

Theories like the EMT and random walk prove that no one can really beat the markets. A cynical point of view is that the market is so efficient that you cannot beat the odds, or that price movement is so random that there is no way to know what to buy. Neither of these theories holds up when analyzed over time, and common sense tells you that the beliefs among people with 'skin in the game' (money in the market) know much more about it than academic theories claim to know.

To understand fundamentals you have to be an accountant, and to understand technicals you need a degree in math. Some people have concluded that any form of detailed analysis requires credentials. However, the basic fundamental and technical indicators everyone needs to study can be comprehended without any special training or knowledge. It's all a matter of side-by-side comparison, long-term trend observation, and common sense. A good rule to follow is that if something is too complicated to understand, it probably is not a valuable indicator, either.

By Michael C. Thomsett

Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.